The Correlation is Not Always Obvious…

20 Sep 2016

Insurance

The intention when purchasing insurance is to plan for and protect against the risk of unforeseen financial loss – an easy enough concept to grasp. A loss caused by physical damage might be relatively straightforward to quantify – if physical damage causes production to be down for 3 months while the facility is repaired, in theory a correlation will likely exist between the scale of the damage, the 3 month shutdown and the financial loss.

But with product recall and other reputational issues, the potential loss from recall can make the correlation less apparent.

A company (or insured) knows its market, its product portfolio, expected sales levels and operating costs. Other things being equal, the company can probably forecast the loss suffered if production is halted for a period of time. However, the financial impact following a product recall can be more complicated where often the scale of the event does not correlate with the downstream financial impact caused by reputational harm.

The financial impact can be difficult to anticipate due in large part to the apparent lack of correlation between the scale of a contamination or recall event and the magnitude and monetary amount of losses that follow.

We see it time and time again. What appears to be a small issue in a small part of the supply chain, quickly becomes a large scale event because of reputational harm. In contrast, we also see large issues result in small events in terms of the losses that follow. What accounts for the difference?

Many factors influence the magnitude of a loss. These can include the product’s position in the supply chain, the brand name of those affected, the sensitivity of the product (for example a baby or pet product) or the scale of the supply chain in which the affected inventory may be used, as well as how well (or poorly) the situation is handled. Any of these elements or a combination may be the difference in the damage calculation following an event.

Certain aspects of a recall loss can be reasonably anticipated. Take the company’s own inventory for example: since batch sizes between equipment cleanings are a known element of production, a manufacturer can reasonably forecast how much product would be affected within a defined number of batches. Other financial losses are even more straightforward – logistics, storage, testing and destruction costs are readily identifiable and often correlate to the number of affected products or inventory. Our experience also tells us that these recall expenses will not be the largest portion of the financial loss.

The more challenging element is anticipating the loss of sales and business income loss that results from a recall event. Experience tells us that statistically this can be the largest part of the loss. Often it is the difference between a $1m problem and financial impact exceeding $25m. This is not only driven by customers seeking refunds for past sales, but more critically by the potential for reputational harm and a loss of customer confidence, which will undoubtedly affect future sales. It is all a question of how big the impact will be, and as always, how that can be linked to the events that have transpired.

The magnitude of a business income loss can quickly grow and become disproportionate to the event leading to the loss.

Companies should be ready with a detailed response plan that will help mitigate the financial losses and reputational harm resulting from a product recall. The future will always have unknowns, but as the data available on recall losses grows, we are in a better position to anticipate the depth and breadth of the potential financial loss, recognize the importance of reputational risk and be ready with a response.

Be prepared – handled well, the risks and losses can be mitigated. Get it wrong, and it can be a whole different story…

If you are interested in seeing how RGL maps product recall risk, get in touch with Simon Oddy.

Disclaimer

The views or thoughts contained in this blog and in individual posts are those of the individual author and are intended as an example for discussion only and not advice or a prediction of outcome. Each situation an entity or individual may encounter is different and will have diverse facts that affect any analysis and may change the conclusions or opinions expressed here.

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